Tuesday, October 27, 2009


The issue of whether monetary policy is an appropriate tool to try to burst asset bubbles, or prevent them from actually forming, has been the subject of an ongoing debate since the meltdown of the stock market in 2001 and the most recent nosedive of the housing sector and its well-known by now devastating implications for the financial system and the economy. In that context, Alan Greenspan's infamous "hands off" approach has been called sharply into question in the last couple of years and a steadily growing chorus of policy-makers seems to realize the need for central banks to find ways to better contain asset bubbles.

This issue is now pushing to the forefront of both markets' and analysts' attention, as a number of central banks around the world are already moving to tighten monetary policy (Australia, Norway), or gearing up to do so in the foreseeable future. The motivating factor for such an approach is ostensibly a concern that asset bubbles are forming anew in some countries, fueled by the unprecedented amount of liquidity that had been previously injected into their financial systems in the context of dealing with a major financial crisis.

The thinking that naturally flows from that (also reinforced by the realization of how damaging inflated asset prices can be if left unchecked) is that central banks are now on the lookout for early signs of such bubbles forming and, therefore, quicker to switch to a tightening mode to avoid repeating past mistakes. This would presumably apply to the Fed as well, given that the rebound in stock prices since March has been viewed by some- unjustifiably- as excessive.

If things were only that simple...

Central banks of the major industrialized economies (U.S., Euro area, U.K.)- which have, suffered the most from the recent financial crisis- have extremely limited room for maneuver in the midst of the ruins that the events of the last two years have left behind. These economies are only now to starting to emerge from the sharpest economic contraction in many decades and with financial systems which have, to varying degrees, been deeply scarred by it.

It is unrealistic, bordering on plain naivete, to expect any of these central banks to engage in pre-emptive strikes against the potential risk of an asset bubble in their system, in the midst of a generally expected moderate and halting economic recovery, underpowered by far-from-stable banking systems. Those central banks simply do not have that luxury, as their paramount concern remains to ensure that the economic recovery gains some traction first. As a result, their hands are essentially tied by the harsh realities of a complex and unforgiving environment that shows little respect for theoretical economic models or abstract concepts of preventing bubbles. This predicament is probably more applicable in the case of the Fed and the Bank of England and, perhaps, slightly less so in the case of the ECB, which has at times shown signs of and impressive, and calculated, imerviousness to seemingly desperate needs of the Euro economy.

The central banks around the world that can afford at this stage to consider tightening policy out of fear of emerging bubbles domestically are those of countries with overall sound banking systems, and economies which (as a result of the latter) are already showing credible signs of an economic rebound that cannot be derailed by any tightening action in pursuit of bubble containment.

In the U.S, irrespective of what the stock market does in the next few months, the Fed can only limit itself to the frustrating role of a passive observer, as it cannot go after it in an attempt to implement lessons that may have been learned from the experience of the last decade (assuming that such lessons are pointing to some sort of clear and useful policy action, in the first place- but this will be the subject of another article).

In other words, the Fed may still not be in a position to do much about any bubble formation in the foreseeable future, as it operates within an environment that is decidedly not under its own control.

To recite a major political philosopher of the 19th century, "Men make their own history but not in circumstances of their own choosing".

Anthony Karydakis